Can crises be curbed? Hayek vs Keynes…

This one is by Norges Bank Deputy Governor Jon Nicolaisen. As he is a central banker, what more to expect than whether one should intervene ot let markets work during a crisis:

On 17 October 1932, a letter on the subject of public and private spending was published in The Times newspaper. The letter was signed by several economists, one of whom was John Maynard Keynes. In the letter, Keynes argues in favour of public spending:

“If the citizens of a town wish to build a swimming-bath or a library, or a museum, they will not, by refraining from doing this, promote a wider national interest. […] Through their misdirected good will the mounting wave of unemployment will be lifted still higher.”

Two days later, on 19 October 1932, another letter was published in response. This letter was also signed by several economists, among them Friedrich Hayek:

“… many of the troubles of the world at the present time are due to imprudent borrowing and spending on the part of the public authorities. […] the existence of public debt [on a large scale] imposes frictions and obstacles to readjustment […] If the Government wish to help revival, the right way for them to proceed is, not to revert to their old habits of lavish expenditure … “

The debate between Keynes and Hayek took place at a time when millions of people were out of work. Governments, firms and households were heavily in debt and many banks were on their knees. In many countries, deflation made debt even heavier to bear. At the same time, pessimism and caution put a damper on the willingness to spend. Deflation and unemployment led to a low level of consumption, and investment that could have generated jobs and growth was held back.

The question is, then, can the authorities curb a crisis by spending borrowed money? According to Keynes, spending would not only prevent the economy from sinking even lower, it would also reduce the extent of the crisis and bring the economy back into balance more quickly. Or was Hayek right when he claimed that misjudged attempts to curb a crisis by means of debt-financed spending can sow the seeds of a subsequent and even deeper crisis?

According to Hayek, measures should be focused on the underlying challenges, such as public debt, that had created the crisis. In Hayek’s opinion, higher public debt would inevitably end up funding unproductive investments and consumption in the public sector, which would lead to low growth. Instead, government budgets should be brought into balance and regulations hampering economic activity should be removed. In Hayek’s view, this would over time provide the basis for healthy, self-driven economic growth, even if the measures taken might deepen the crisis in the short term.

Keynes won the public debate in the 1930s. His views influenced economic policy in the West, particularly in the post-war years. However, Keynesian policies would later prove to have their weaknesses too.

The speaker picks examples from Norway to show why both Keynes and Hayek are right in their own ways. In the end he sums up:

In my introduction, I posed the question: can crises be curbed? quickly followed by: can misjudged attempts to curb a crisis sow the seeds of an even deeper crisis?

Keynes and Hayek did not come to agreement on how a crisis should be managed. Their debate is still relevant today. Keynes advocated the use of public spending to curb crises. Hayek warned against such a policy: the misjudged application of government measures could easily lead to deeper crises and credit bubbles.

Both were right. Crises can and should be curbed, using measures to strengthen the economy’s immune system as well as measures that reduce the impact once the crisis has erupted. This means that government intervention using public funds may be the right approach in a situation of decline and deflation, low interest rates, high unemployment and pessimism. But crisis-related measures must also be focused on the deeper causes of the crisis in order to strengthen economic sustainability over time. Countercyclical policy must not become counterstructural policy.

Crises are not necessarily just an evil. A crisis can lead to reforms and measures that foster progress, as it did in Norway in the 1990s. The regulation of the banking sector in the wake of the global financial crisis is another example. Experiences such as these may give us some comfort in the bleakest of times. The world will go on, even after a deep crisis.